There are speculators and then there are speculators

There has been renewed discussion and debate again about the impact of speculators in the oil market. Some of it has been occasioned by recent enforcement actions against illegal activity.

In May, the US Commodity Futures Trading Commission (CFTC) filed civil charges against Parnon Energy, Arcadia Petroleum and Arcadia Energy SA as well as two individuals for manipulating the price of crude oil in 2008.

The US Federal Trade Commission this week confirmed it had opened an investigation examining whether oil companies, refiners or traders had manipulated crude oil prices.

These events follow endless debate about the drafting of new position limits on futures trading mandated by Dodd-Frank. A number of US Senators, Cantwell lead among them, have criticized the slow pace of action.

One major point of confusion in the discussion is the many different types of activities labeled speculation, and the many different ways in which speculative trading can move prices away from fundamentals. Most discussions simply speak of speculation as if it were one thing. People who are suspicious of markets and people who put all their faith in unfettered markets talk past one another when they speak of speculation.

Here is a quick and dirty taxonomy of 4 different types of speculative trading that can distort the market price.

targeted manipulations, in the form of a corner or squeeze or similar strategies; something like this is what is alleged in the recent CFTC complaint against Arcadia et al.–see the Streetwise Professor for an explication; these usually occur over a short window of time and involve a relative small price differential that nevertheless yields a tidy profit to the manipulator, but there are numerous examples of attempts on a much grander scale, notably the Hunt brothers manipulation of the silver market in the late 1970s and early 1980;

certain speculative trading strategies; while speculative traders tend to unite and blanket defend their activity as providing liquidity to the marketplace, in some cases the activity is parasitic; algorithms that profit by jumping in front of other orders do not provide liquidity, but effectively charge a ‘tax’ to legitimate traders and undermine the functionality of the marketplace; similarly, the ‘market timing’ strategy executed by a host of hedge funds in the early 2000s against mutual funds invested in overseas stocks was another ‘tax’ on legitimate investors; the recent ‘flash crashes’ have highlighted how some strategies of some of these investors can sometimes distort market prices wildly; more often the damage arises not from a clear divergence of the market price away from fundamentals, but in the form of an endless small drip of small amounts of money as the price bounces away from fundamentals briefly and imperceptibly to the advantage of the speculator and the disadvantage of legitimate traders;

in and outflows of funds from passive investors such as commodity index funds; there is significant debate about whether or not or by how much the flow of orders can move the oil price, and for how long; John Kemp of Reuters has a recent discussion of the different economists taking sides on this issue;

an asset bubble caused not by a narrowly identifiable group of investors, nor by a single manipulative channel, but by a widespread irrational belief among many different investors that oil prices will go up and up and up; this last type of speculative bubble is what I discussed in my paper Black Gold, Fool’s Gold; Robert Shiller’s recent NYT piece discusses similar bubble dynamics in housing.

These four types of speculation and price distortion are very different from one another, and a little attention to the differences could help to improve the quality of the debate.

For example, see James Hamilton’s excellent exposition of what is alleged in the CFTC case; although the case is about manipulation in 2008, and so sounds like it addresses the enormous spike in the oil price in 2008, it is clear that the alleged manipulation is not in any way shape or form about the 2008 price spike.

Many of the statistical tests applied to the third type of speculation are irrelevant to the fourth type, although many economists have tried in vain to dismiss talk of a bubble on the basis of these tests alone.

It is important to make the distinction between the 4 types of speculation and distortion as we consider new policies and regulations. Obviously no policy will automatically address all 4 types simultaneously. We need to craft the solution to the problem.

A quibble: the CFTC did not allege a corner or squeeze. Its case is more accurately described as a price impact manipulation. I analyzed this case on Streetwise Professor.

The taxonomy is useful. The shape-shifter like nature of allegations about speculation and its effects make it very difficult to respond to them. The empirical and policy implications of the different types of speculative effects are very different, as I discuss here. An effective policy first requires some diagnosis of exactly how speculation is distorting–distorting, not affecting prices. That is seldom done with any precision or consistency. There is even a widespread failure to identify exactly what price is affected. For instance, the flow of investor money and financialization generally should primarily impact risk premia.

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We use this blog to discuss with our students issues in risk management for non-financial corporations. The blog addresses interesting events in the news, as well as advances in financial analysis. We have made the blog public to encourage valuable contributions from former students, colleagues and others in industry, government and academia.

The content of the blog is closely aligned with the material in our lecture notes on Advanced Corporate Risk Management (MIT course 15.423). A website with the notes and associated materials will be coming soon.